Professional Documents
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North-Holland
Daniel W. COLLINS
University of low, Iowa Ci+, IA 52242, USA
Duke lJniversi{v, Durhum, NC 37706, USA
S.P. KOTHARI
University of Rochester, Rochester, NY 1462 7, USA
Stock price change associated with a given unexpected earnings change (the earnings response
coefficient) exhibits cross-sectional and temporal variation. We predict and document evidence
that the earnings response coefficient is a function of riskless interest rates and the riskiness,
growth and/or persistence of earnings. The earnings response coefficient also varies cross-section-
ally with the holding period return interval. Collectively, our results explain the previously
reported differential earnings response coefficient with respect to size. Moreover, by including the
factors noted above, the empirical specification of the earnings/returns relation is significantly
improved.
1. Introduction
*This paper has benefited from workshop discussions at the University of Chicago, Iowa,
Michigan, Minnesota, MIT, Ohio State, Rochester, the Stanford Summer Camp, and the Interna-
tional-Symposium on Forecasting at Boston. We acknowledge R. Ball, V. Bernard, L. Brown, S.
Choi. P. Easton. J. Fellineham. G. Foster. T. Harris, P. Healv R. Kormendi, R. Leftwich, S. Linn.
T. Linsmeier. B. Lipe. RrLundholm, J. Ohlson, B. Ricks, M. Weisbach, P. Wilson, R. Young, J.
Zimmerman, M. Zmijewski, and especially R. Watts and S. Penman (the referee) for their
comments on earlier versions of the paper. We are particularly grateful to Johannes Ledolter and
Mike Rozeff for extended discussions.
and ei, is a random disturbance term assumed to be distributed N(0, u,). The
slope coefficient, b, is called the earnings response coefficient (ERC).l
Generally, the returns/earnings relation is investigated using either an
events study or an association study method. The event studies infer
whether the earnings announcement, per se, causes investors to revise their cash
flow expectations as revealed by security price changes measured over a short
time period (typically, 2-3 days) around the earnings announcement. Exam-
ples include Foster (1977), Hagerman, Zmijewski, and Shah (1984), and
Wilson (1986, 1987). In essence, the focus is on whether earnings announce-
ments convey information about future cash flows.
In an association study, returns over relatively long periods (fiscal quarters
or years) are regressed on unexpected earnings or other performance measures
such as cash flows [Raybum (1986)] or replacement cost earnings [Beaver,
Griffin, and Landsman (1982)] estimated over a forecast horizon that corre-
sponds roughly with the fiscal period of interest. Association studies recognize
that market agents learn about earnings and valuation-relevant events from
many nonaccounting information sources throughout the period. Thus, these
studies investigate whether accounting earnings measurements are consistent
with the underlying events and information set reflected in stock prices.
Typically, causality is not inferred. Rather, the focus is on whether the
earnings determination process captures in a meaningful and timely fashion the
valuation relevant events.
Regardless of the perspective used, the bulk of the extant empirical litera-
ture assumes the returns/earnings relation is homogeneous across firms. The
slope b in eq. (1) is treated as a cross-sectional and temporal constant. Recent
studies relax this assumption to improve eq. (1)s specification and explanatory
power [see, e.g., Beaver, Lambert, and Morse (1980) Ohlson (1983), Miller and
Rock (1985) Kormendi and Lipe (1987), and Easton and Zmijewski (1989)].
By combining alternative valuation models with different earnings process
assumptions these studies provide important insights into factors that explain
variation in ERCs.
This study provides further insights into factors contributing to differential
ERCs in an annual association study context. In contrast to the previous work,
we examine temporal as well as cross-sectional determinants of ERCs. The
temporal variation in ERCs is hypothesized to be negatively related to the
risk-free interest rate. We expect cross-sectional variation in ERCs to be
positively related to earnings persistence and negatively related to firms
systematic risk. In addition, we hypothesize that ERCs are positively related to
growth opportunities that are not likely to be fully captured by persistence
In using the term response we do not imply causality. The term is used in a generic sense to
measure the degree of comovement between security returns and shocks to an earnings series
without necessarily implying that the latter cause the former. The distinction is made clearer
below.
D. W. Collins and S. P. Kothari, Variation in earnings response coefficients 145
estimated using time series models. Our empirical results are consistent with
all these predictions.
We also demonstrate empirically that the earnings/returns relation varies
with firm size, where size is a proxy for information environment differences.*
Differences in information environment affect the extent to which price
changes anticipate earnings changes [Collins, Kothari, and Rayburn (1987)
and Freeman (1987)]. Once differences in the information environment are
controlled by varying the return holding period, there is little difference in the
extent to which price changes covary with earnings changes across firm size.
This explains the differential magnitude of ERCs as a function of firm size
documented in Burgstahler (1981), Freeman (1987), and Collins et al. (1987).
Our analysis also suggests that association studies that use a holding period
corresponding to a firms fiscal period (or between earnings announcement
dates) understate the earnings/returns association. Holding periods that begin
at an earlier point in time and span a longer time horizon enhance the
earnings/returns association relative to the conventional twelve-month hold-
ing periods, particularly for larger firms.
In section 2 we identify the determinants of ERCs using a simple dividend
capitalization model where accounting earnings are assumed to be related to
future dividends. In section 3 we discuss how noise in accounting earnings
measurement and variation in the information environment affect the estima-
tion of ERCs. We also propose ways to deal with these problems empirically.
Section 4 identifies the sample used in our empirical analysis. Section 5
demonstrates differences in the strength of earnings/returns relation for large
versus small firms as one varies the return holding period. Section 6 is broken
into two parts: first, variation in the earnings/returns relation over time and
its association with long-term risk-free interest rates are documented; second,
cross-sectional variation in the earnings/returns relation and its association
with risk, earnings persistence and/or growth are documented. Section 7
summarizes our findings and discusses some of the implications of our results
for past and future research.
then discuss the cross-sectional and temporal determinants of the ERCs which
provide the basis for our empirical investigation. Finally, we compare the
determinants of the ERCs identified in this study with those in the related
literature.
P,,= ft E,(%+k)
k=l
Tfil
{l/i1 + E(fL+,)l>~
where
In writing eq. (2), the future expected rates of returns are assumed known and
the only uncertainty about future prices is due to reassessments through time
of expected future dividends. These assumptions, together with the other
assumptions underlying the Sharpe-Lintner Capital Asset Pricing Model
(CAPM), are sufficient for the multiperiod CAPM to hold [Fama (1977)].
To derive the ERC, we assume accounting earnings are related to future
dividends and, hence, unexpected earnings cause investors to revise their
expectations of future dividends leading to security price changes. Future
expected dividends are assumed to be related to current earnings according to
where X,, is firm is reported accounting earnings for period t. While the
assumption in eq. (3) is ad hoc, it is useful in generating empirical predictions
tested later in the paper. Moreover, the dividends/earnings relation in eq. (3)
underlies, at least implicitly, the empirical analysis in numerous previous
studies, including Ball and Brown (1968), Freeman (1987), Kormendi and Lipe
(1987), and Easton and Zmijewski (1989). The precise values of the hittks will
depend on the particular time series process that earnings follow as a function
of the firms investment and dividend policies. The next section demonstrates
how alternative earnings process assumptions affect the Xitiks and the ERCs.
Substituting eq. (3) into (2):
D. W. Collins and S. P. Koihari, Variation in earnings response coeJicients 141
uR,,= f~
{L[1
[ it+k
x*, + Z
k=l
(5)
>1U&/ft-~>
+E(&+,)I 7=1
where UX,, = X,, - E,-,( X,,) is the unexpected earnings in period t. Eq. (5)
relates unexpected earnings to unexpected returns and the coefficient on
unexpected earnings scaled by price is the ERC (the bracketed term).
Eq. (5) reveals that, ceteris paribus, the ERC is inversely related to the
expected rate of return on a security. Because we assume complete knowledge
of future expected rates of returns consistent with the multiperiod CAPM, we
can substitute the Sharpe-Lintner CAPM relation in each period:
Table 1
Persistence factors under different ARIMA earnings processes
or
Earnings process AE,(X,+,) =+ku, interest rate of rb
ARIMA(O.l, 0) 1
[random walk]
(19W1
1-O
r a,
L-1
ARIMA(O.1, 1) (1-B)u, forall k
[Beaver, Lambert,
and Morse (1980)]
ARIMA(1,O.O)
++1
[Easton and
Zmijewski (1989)]
u, = X, - E,_ i( X,) is the shock in period ts earnings, Earnings follow an ARIMA time series
prYess.
Following Kormendi and Lipe (1987) and Flavin (1981), the present value of the revisions in
earnings expectations caused by (I, over an infinite horizon for an ARIMA( p, d, q) process is a
function of the AR( c$) and MA( 8) paramenters as follows:
One plus the bracketed term in the last column gives the theoretical earnings response coefficient
for that particular earnings specification.
parameter ARIMA estimates derived from lengthy time series represent some
sort of a weighted average of changing growth opportunities over time.
Because we expect the persistence estimates from time series models to be
deficient in accurately reflecting current growth opportunities, we include a
proxy for the latter as an additional determinant of ERCs.
In addition to the three cross-sectional determinants of the ERC, we
hypothesize interest rates as a temporal determinant of the ERC. To derive a
temporal relation between interest rates and the ERC, we assume that the
expected rates of returns in the future periods vary over time. That is,
E(Rit+7) can vary over t. We further assume that the current risk-free interest
rate is highly positively autocorrelated with the future risk-free interest rates.
Because the risk-free interest rates are a component of E(R,,+,), the higher the
current risk-free interest rate the higher the expected rate of return on the
security in the future periods. Therefore, we predict a negative relation
between interest rates and the ERC through time.3
In hypothesizing the negative temporal association between interest rates
and the ERC, we deviate from the assumption underlying the discounted cash
flow model and the multiperiod CAPM that all the future E( R,,,,) are known
at time t and, thus, cannot vary with t. However, relaxing this assumption
generates an interesting empirical prediction and is consistent with the evi-
dence that both nominal and real interest rates change through time [see, e.g.,
Ibbotson and Sinquefield (1985)]. If the ERC is derived using continuous time
valuation models like Merton (1973) or by allowing uncertainty in future
commodity prices and the future investment opportunity sets [Long (1974)],
the effect of interest rate variation through time on the ERC will enter into the
model more directly. These extensions are beyond the scope of this paper, but
are fruitful avenues for future research.
To summarize, we identify four factors contributing to cross-sectional and
temporal differences in the ERC. The ERC is positively related to earnings
persistence and economic growth opportunities. The ERC is negatively related
to the securities future expected discount rates. The discount rate is made up
of (i) the risk-free interest rate, R,, and the market risk premium, and (ii) the
firms CAPM beta risk. Because R, and the market risk premium are the same
for all firms, they obviously are not a source of cross-sectional variation in
ERCs. The ERCs are negatively related to the interest rate levels through time
and the CAPM beta risk in the cross-section.
3We use a partial equilibrium analysis to examine the interest rate effect on the ERG. Interest
rate changes affect, among other things, the saving/investment decisions of individuals and
corporations which, in turn, affect the firms future cash flows. Incorporating these effects on cash
flows and their present values to derive a relation between interest rates and the ERCs requires a
complete equilibrium analysis that is beyond the scope of this paper. We essentially ignore the
saving/investment and associated cash flow implications of interest rate changes in making our
predictions.
D. W. Collins und S. P. Kothari, Vuriation in eurnings response coefficients 151
The covariance between unexpected returns (UR ir) and unexpected earnings
(UR,,) can be summarized as follows:
point in time differs from a simple time series earnings expectation proxy. The
presence of competing (and more timely) sources of information in addition to
reported earnings renders the time series earnings expectation a noisy measure
of UXi, [see, e.g., Collins et al. (1987) and Freeman (1987)].
Measurement error in a UXi, proxy attenuates the ERC and makes it
difficult to detect the influences of the ERCs determinants. The bias in an
estimated ERC can be substantial. Indeed, evidence in Beaver et al. (1980)
suggests that ERCs estimated at the individual security level using a time
series earnings expectation proxy for UX,, understate the true or theoretical
ERCs by as much as 70-80%, on average.
If we could obtain a better measure of the markets earnings expectation at
time r - 1, the measurement error problem in a proxy for UXi, would be
reduced. However, empirically this is difficult. While analysts forecasts are
better than time series proxies [Brown et al. (1987a, b)], they are not available
in a machine-readable form over the time period examined in this study and
they are generally available only for the larger, more widely held firms. An
alternative approach to reduce the measurement error problem is to set t - 1
(i.e., the beginning of the holding period) at a point such that the time series
proxy (in our case, a random walk specification) approximates the markets
earnings expectation. We adopt the latter approach by varying the return
window.
Varying the return window ensures that a particular UX,, proxy matches up
closely with the true (but unobservable) market earnings expectation and
provides a specification check on previous work relating earnings changes to
security returns. This allows us to u e the same earnings expectation model
across all firms (which is typically done in empirical work) and find the point
in calendar time when that particular proxy best approximates the markets
earnings expectation for a particular firm. This ensures that the estimated
response coefficient fully captures the markets valuation of unexpected earn-
ings. Varying the return window also allows us to assess how this affects the
earnings/returns association as measured by adjusted R* across firm size.4
In addition to error in UX,, proxy, cross-sectional differences in the infor-
mation environment contribute to nonrandom variation in the earnings/
returns relation. If firm size is a proxy for information environment differ-
ences, then different size firms will exhibit different ERCs on measuring UXjrs
over a fixed holding period for all firms [see, e.g., Collins et al. (1987)]. In this
sense returns measured over fixed holding periods contain error. Holding the
earnings expectation model and the return cumulation period constant across
all firms can result in a spurious association between firm size and ERCs in an
41f returns are the dependent variable and we vary the length of the holding period from one
model to another, then the adjusted Rs are no longer comparable since the total sum of squares
will differ from one model to another.
D. W. Collins and S.P. Kothari, Variation in earnings response coeficients 153
See Beaver et al. (1980) for a discussion of alternative grouping procedures in direct regression
to mitigate measurement error in I/X,, proxies. Beaver, Lambert, and Ryan (1987) discuss reasons
for preferring reverse regression over these grouping procedures.
6This approach assumes implicitly that the market is able to forecast accurately the prior years
earnings number well in advance of its actual release. Thus, using the prior years earnings as a
basis for predicting the current years earnings (even though the former has not yet been released)
only assumes that the market makes an unbiased assessment of what the number will actually be.
To the extent this assumption does not hold, it weakens the earnings/returns association when
return cumulation begins in an earlier period. Evidence in Beaver et al. (1980), Collins et al.
(1987), and Freeman (1987) suggests that the market anticipates earnings changes from t - 1 to t
well before earnings for t - 1 are reported.
154 D. W. Collins and S.P. Kothari, Variation in earnings response coefficients
based largely on the evidence in Beaver, Lambert, and Ryan (1987). In section
2 we posited that the ERC is related to four factors: earnings persistence (+),
growth (+), risk (-), and interest rates (-). In reverse regressions, these
functional relations are inverted. That means the RRC increases in risk and
interest rates and decreases in earnings persistence and growth. These predic-
tions are expected to hold when earnings changes are scaled by price which is
the scaling variable according to the analysis in section 2 and in Christie
(1987). However, if earnings changes are scaled by previous years earnings as
in Beaver et al. (1980) and many other earnings association studies, then RRC
is likely to exhibit lesser association with the four determinants for reasons
discussed in section 3.3.3.
The inverse of the estimated RRC is the upper bound for ERC. Therefore,
attempts to infer the earnings process or to place other economic interpreta-
tions on the inverse of the estimated RRC must be approached with caution.
Accordingly, we interpret the RRCs conservatively and use significance tests
only to judge whether its determinants have the predicted signs.
??
_._.3. Scaling factor for earnings changes
(1) p is likely to vary with changes in risk-free interest rates or risk premia.
Casual observation suggests that P/E ratios are relatively high (low)
during low (high) interest rate periods. Therefore, in a relation between
Because annual earnings change is used as proxy for UX, we use AX instead of UX in the
remainder of the paper.
Some argue that price is not an appropriate deflator and conclude, at least implicitly. that some
other deflator like previous years earnings is a more appropriate deflator [see. e.g., Lustgarten
(1982)].
156 D. W. Collins and S.P. Kothari, Variaiion in earnings response coefficients
nominal returns and earnings changes, ERCs are likely to vary over time
even when scaling by X,_ i.
(2) While price is expressed as a multiple of expected or current earnings, the
prices/earnings relation is unlikely to be deterministic. A more realistic
prices/earnings relation would be
Identifying firms from the Compustat Research Annual tape reduces the severity of the
survivorship bias inherent in sampling only from the Compustat Industrial Annual tape. Also,
data for firms delisted because of mergers, acquisitions, and takeovers are available on the
research tape for the years prior to their mergers, etc. We increase the sample size by approxi-
mately 20% by using the research tape.
D. W. Collins and S. P. Kothari, Variation in earnings response coefficients 157
periods. The CRSP monthly returns tape contains only NYSE-listed firms. We
use monthly return data to estimate systematic risk because beta estimates
using daily returns data are biased and inconsistent [Scholes and Williams
(1977)]. The subset of NYSE firms for which monthly return data are available
on the CRSP tapes for eight consecutive years ending in year t + 1 is included
in the final sample. Monthly returns for the five years up to the end of year
t - 2 are used in estimating the firms systematic risk (market model betas)
and returns over varying lengths of time for the next three years (i.e., years
t - 1 to t + 1) are used in the regression analysis. These criteria yield a sample
of 9776 firm-year observations. The number of observations in each year
varies from 519 in 1968 to 730 in 1978.
The decision to exclude observations with ISA X,( > 200% may seem arbitrary, but it is
consistent with previous research in this area.
158 D. W. Collins and S.P. Kothari, Variation in earnings resporwe coeJ%ents
Table 2
Summary statistics for market value of equity, risk, and change in earnings: Sample of 9776
firm-years from 1968-82.=
Standard
Variable N Mean Median deviation Minimum Maximum
Initially any firm listed on the Compustat Industrial Annual or the Compustat Annual
Research tape with a December 31 fiscal year-end and a minimum of three years of earnings data
during 1968-82 is included in the sample. From this sample, the subset for which monthly return
data are available for eight consecutive years ending in 1969-83 is included in the sample
analyzed in this study.
bMarket value of equity is defined as the beginning of the year share price times the number of
shares outstanding; in millions of dollars.
Market model beta estimated by regressing monthly returns over five years on the NYSE
equally weighted index.
dMarket model betas of three securities are negative.
Percentage change in earnings, WAX,, is change in earnings per share from year t - 1 to r
divided by the earnings per share for year t - 1, all adjusted for stock splits and dividends. A total
of 731 observations with negative denominators or \%A X,1 z 200% are excluded.
Change in earnings scaled by price, A X,/P,_ Lr is change in earnings per share from year t - 1
to t divided by share price at the beginning of year t. A total of 58 observations with
IAX,/P,_,l> 100% are excluded.
Once again, the decision to exclude observations with /A X,/P,_ ,( > 100% is arbitrary, but, as
can be seen from table 2, these observations are more than nine standard deviations away from
the mean. Inclusion of these observations in the sample would likely have an undue influence on
the estimated regression coefficients.
D. W. Collins and S. P. Kothari, Variation in earnings response coefficients 159
with firm size. If firm size is correlated with risk, growth, and persistence
(which seems likely), then failing to control for differences in the lead-lag
structure of returns and earnings will confound tests for differences in the
earnings/returns relation due to the factors identified earlier.
To demonstrate the relation between firm size and the lead-lag structure,
we regress earnings changes (scaled by Pt_lor X,_,) on security returns from
the contemporaneous and lagged fiscal year according to the following model:
where, consistent with previous research, R;,is measured from April of year t
to March of year t + 1 and R it- I is measured in an analogous fashion.
Results in the first two rows of table 3, using all stocks in the sample, reveal
that coefficients on both current and lagged years returns are of comparable
magnitude and highly significant. l2 Thus a nontrivial portion of the events
contributing to accounting earnings changks in the current period are captured
in security returns from an earlier period.
To ascertain whether the degree to which lagged returns explain earnings
changes varies with firm size, we partition our sample into three equal-sized
groups by ranking firms each year according to the beginning of year equity
market vales. Results of estimating eq. (8) for the small, medium, and large
firm groups are reported in the lower portion of table 3. Lagged years returns
possess significant explanatory power for all three size groups. However, the
magnitude and significance of f1 in relation to f2 suggest that R,+,is more
important in explaining earnings changes for large versus small firms, which is
consistent with Collins et al. (1987) and Freemen (1987).
While the above analysis suggests that the earnings/returns association is
enhanced by including returns from an earlier time frame, the results do not
identify exactly how far back one should go. This is difficult to specify a priori
and will vary as a function of the timing of valuation relevant economic
events, the nature of a firms information environment, and how quickly
economic events are captured in the accounting earnings numbers. Basically,
then, it becomes an empirical issue.
To shed some light on this issue, we regress earnings changes on returns
where the return measurement is started at varying points in time and
extended over varying time frames. We always use buy-and-hold returns.
Specifically, we vary the start of the return cumulation process from January
of fiscal year t - 1 to June of fiscal year t and allow the length of the holding
*The t-statistic may be overstated because cross-dependencies are ignored. However, even after
downward adjustments the p-value is likely to be less than 0.01.
160 D. W. Collins and S.P. Kothari, Variation in earnings response coejicients
Table 3
Pooled time series cross-sectional regression of earnings changes on contemporaneous and lagged
security returns: 1968-82.a
I ,. ,.
Dependent
variable Firm sizeb NC ( t-s&)d (r-skgd ( t-s:2at)d Adj. R2
t3We also used periods longer than 18 months, but the earnings/returns association is
maximized using returns measured over periods shorter than 18 months. We, therefore, do not
report these results.
D. W. Collins and S. P. Kothari, Variation in earnings response coefficients 161
change variables, i.e.., AXJP,_, and %AX,, as the dependent variable. Since
the dependent variable is the same across all models, adjusted R2 is the
criterion used for identifying the starting point and length of cumulation
period that maximizes the earnings/returns association.4 Obviously our re-
sults are sample- and period-specific and only indicate the sensitivity of the
earnings association tests to the length of the holding period return. Hopefully,
these results will guide future research in specifying return holding periods in
association study contexts.
Adjusted R2s from the regressions of SAX, on returns measured over
alternative periods for the large and small firm portfolios are plotted in figs. 1
and 2.15 Fig. 1 reveals that the length and starting month of the return
measurement have a dramatic effect. For example, the typically selected
12-month April to March return period results in an adjusted R2 of 2.41%
which suggests a weak association between large firms price and earnings
changes. However, when the 12-month period begins in January the explana-
tory power jumps to 6.49%. The maximum adjusted R2 of 10.94% is attained
when a 15-month period starting in August of year t - 1 is used. Thus, the
explanatory power for large firms increases substantially by increasing the
length of the holding period from 12 to 15 months and by measuring returns
from August of year t - 1 instead of April of year t. The same return
measurement period maximizes the models explanatory power for medium
size firms and overall the results are quite similar to those in fig. 1.
Turning to fig. 2, for small firms, adjusted R2 is maximized once again using
a 15-month period but beginning in November of year t - 1. This is consistent
with the regression results for large and small firms reported in table 3 and the
evidence in Freeman (1987) and Collins et al. (1987). The maximum adjusted
R2 for small firms is 9.34%.
Comparing figs. 1 and 2 demonstrates clearly the systematic differences
between large and small firms in the extent to which alternative holding
periods dominate the conventional April-March or January-December peri-
ods. There are many fewer holding periods that dominate a January-Decem-
ber holding period for small firms as compared to large firms. The association
between earnings and price changes is maximized for holding periods (of fixed
14Conclusions based on adjusted Rs are not affected by our choice of reverse regression. This
follows because in case of simple regression adjusted R* is unchanged when the independent and
dependent variables are interchanged [see Maddala (1977, pp. 77-79)]. Our discussion of the
sensitivity of the degree of association to length and cumulation period of returns ignores
magnitudes of slope coefficients from all the regressions. The magnitude of the slope coefficient is
maximized when adjusted R* is maximized since R* is an increasing function of the estimated
slope when it is positive.
To improve the visual clarity of the graphs, figs. 1 and 2 do not plot adjusted Rs when
returns are measured over 17 and 18 months. The results for A X,/P,_ I are virtually identical to
those reported here.
D. W. Cohs und S. P. Kothari, Variation in eurrtings response coeficients
Jan, t - Dee, t
0 I I I I I I -J
0 1 6 12 16
at- 1 1
t --__
Fig. 1. Large-firm sample results: Association of various holding period returns with earnings
changes in period t. Month 1 is January of fiscal year t - 1 and month 18 is June of fiscal year f.
D. W. Collins and S. P. Kothari, Variation in earnings response coefficients 163
I
r Jan, I - Dee,
t - Mar. I+1
0 1 6 12 16
c------- I- 1 t --__
Fig. 2. Small-firm sample results: Association of various holding period returns with earnings
changes in period t. Month 1 is January of fiscal year t - 1 and month 18 is June of fiscal year t.
164 D. W. Collins and S. P. Kothari, Variation in earnings response coefficients
length) that begin at an earlier point in time for large firms compared to small
firms.16
To summarize, a conventional 1Zmonth return period understates the
earnings/returns association, particularly for larger firms. The association is
maximized when returns are measured over 15 months starting from August of
year t - 1 for large and medium firms and November of year t - 1 for small
firms. All further analysis is performed using returns measured over the
15-month intervals appropriate for each size grouping. In the remainder of
the analysis the AX,/P,_, variable is defined as AX, scaled by price at the
beginning of the appropriate 15-month return interval for each firm. This
ensures that the scale variable is consistent with the model in section 2.
t6A potential limitation of extending the return interval to include lagged periods returns is that
part of the price change in f - 1 is likely to capture shocks or changes in accounting earnings for
that period. If there is positive serial correlation in successive earnings changes this may create a
correlated omitted variables problem and overstate the coefficient on the lagged periods return.
This potential problem can be addressed by including lagged earnings changes as an additional
explanatory variable. Nayar and Rozeff (1988) explore this issue using an earnings/returns
specification and sample virtually identical to ours. They find only modest negative partial
correlations between successive earnings changes and the coefficient on lagged returns remains
positive and highly significant with lagged earnings changes included as an additional explanatory
variable.
We also used one-year T-bill rates with slightly weaker but similar results as reported here.
These results are available from the authors upon request.
Even if we were to identify the term structure of interest rates, it is not obvious how to use
that information in relating the response coefficient to interest rates. It seems that some kind of a
weighted average interest rate is called for where the weights are proportional to the expected
levels of interest rates and inversely proportional to their timing. We do not know the extent of
improvement in the relation between interest rates and RRCs that would result from such an
exercise and leave it for future research.
D. W. Collins and S.P. Kothari, Variation in earnings response coeficients 165
Table 4
Product moment and rank order correlations between long-term Government bond yields and
annual return response coetlicients estimated by re essing annual earnings changes on
security retums.a. Fr
Long-term Government bond yields used as proxies for risk-free interest rates are taken from
Ibbotson and Sinquefield (1985).
bAnnual return response coefficients (n,s) are estimated from the following annual reverse
regressions: %A X,, or A X,,/P,,_ 1= %, + yl, R,, + E,,. The sample selection criteria employed to
obtain data for these regressions are given in footnote a to table 2.
A X,/P,_ 1 is change in EPS from year t - 1 to t divided by share price at the beginning of the
relevant return period (i.e., 12- or 15-month period). A total of 58 observations with /A X,/P,_ 1I>
100% are excluded.
%AX, is change in EPS from year t - 1 to t divided by the EPS for year f - 1. A total of 731
observations with negative denominators or IBA X,1 > 200% are excluded.
Return period refers to the independent variable in the annual regressions. R,, is raw return on
security i over the relevant return period.
dReturn period January-December is 12 months starting from January of fiscal year t for each
security. The 15-month return period starts in November of fiscal year t - 1 for the small firms
and starts in August of fiscal year t - 1 for the medium and large firms,
All correlations are based on 15 annual observations for the period 1968 to 1982.
rates and RRCs. The p-values are small despite only 15 annual observations
(1968-82) used to estimate correlations. Correlations using response coeffi-
cients based on 1Zmonth returns are comparable to those based on 15-month
returns.
As expected, the correlations when %AX, is the dependent variable in the
earnings/returns relation are smaller compared to those using A X,/P,_,.
Using 15-month returns and SAX,, product moment (rank order) correlation
between the response coefficient and interest rates is 0.55 (0.50) which has a
p-value of 0.034 (0.056). These results are consistent with interest rate fluctua-
tions having less influence on response coefficients estimated with the previous
years earnings as the scale factor on AX,. However, the correlations are still
consistently positive and statistically significant. Thus, the sensitivity to inter-
est rates is reduced but not eliminated by using earnings as the scale factor. A
likely reason for the association is that the response coefficient for year t also
reflects the effect of any interest rate change during the year on the returns on
all securities.
(9)
where
R,, = return measured over the appropriate U-month period for the small,
medium, and large firms,
MB,, = market to book value of equity ratio, calculated at the beginning of
year t,19
84, = market model systematic risk.20
The coefficient on R,,, yl, is expected to be positive. When AX, is scaled by
P r_l, y2 is hypothesized to be negative because, in the reverse regression, the
RRC is decreasing in growth. The effect of risk on the RRC is expected to be
positive. When scaling by X,_, we make no predictions on the signs of the
latter two coefficients for the reasons noted in section 3.3.3.
The results of estimating eq. (9) are reported in table 5. The top number
across from each independent variable is the sample mean of the parameter
estimates from the 15 yearly cross-sectional regresssions, and the t-statistic is
calculated from the standard error of the sampling distribution of parameter
estimates. Since statistical inferences are based on standard errors from the
When book value of equity was negative (4 firm-year observations). MB,, was set equal to
zero. This is done because negative MB,, values do not have an economic interpretation in the
context of the regression model being estimated. To avoid undue influence of very large values of
MB,, on the regression coefficient estimates, MB,, > 5 values are set equal to 5 (less than 5%
firm-year observations). All the results are insensitive to truncating extreme values at MB,, = 3, 4,
or 6.
*We also estimated eq. (9) and all other models in the remainder of the paper by nominally
classifying firms into high and low growth or risk portfolios. That is, we did not use the market to
book ratios or beta as a continuous variable. In the regressions, the independent variables were
dummies for risk or growth times R,,. The dummies were assinged a value of 1 for high growth
firms or high risk firms, and 0 for low growth or low risk firms. The high/low classification was
redetermined in each year. Similarly, when interest rate and persistence were included among the
independent variables, high interest rate years or high persistence firms were assigned a value of 1
and 0 otherwise. The primary motivation for using dummy variables instead of continuous
variables was that these variables are likely to be measured with error. All the results using
dummy variable times returns instead of the continuous variable times returns are virtually
indistinguishable from those reported in this paper. All these results are available to interested
readers.
168 D. W. Collins and S.P. Kothari, Variation in earnings response coefficients
Table 5
Effect of risk and growth expectations on the response coefficient from an earnings/price relation:
Annual regression analysis from 1968-82.a
AX,,/P,,-, or %A&, = YO, + x,R,, + YW+% * 4, + n,B,, * R,, + E,,
time series sampling distribution of the regression coefficients, they are free
from the cross-sectional dependence problem described in Bernard (1987).
Results using the A X,/P,_, variable are uniformly consistent with our
hypotheses. The ur coefficient on return is positive and significant. v2 on the
growth/return interaction is equal to -0.021 and reliably negative as pre-
dicted. Similarly, the response coefficient increases in risk as seen from the
coefficient estimate of 0.028 which is significant at 1% level. The evidence
suggests risk and growth (and/or persistence) significantly impact the RRC
when earnings change is scaled by price.
The coefficient estimates on the return and growth variables from the
regression using %AX, as the dependent variable have the same sign as when
AX, is scaled by P,_l. The coefficient for which a prediction can be made, j$
is positive and highly significant. The coefficient on the growth/return interac-
tion (j$) too is significant and negative. Thus, when X,_, is the scale variable,
the RRC is significantly influenced by growth (and/or persistence). The
risk/return interaction (7s) is not significantly different from zero. This result
D. W. Collins and S. P. Kothari, Variation in earnings response coefficients 169
where Db8 to D,, are dummy variables taking on a value of 1 for data from
year t and 0 otherwise and I, is the long-term risk-free interest rate in year t.
All other variables are as defined earlier. We do not include R,, as an
independent variable because, when annual dummies are included, Ri, and
I * Ri, are almost perfectly correlated. Note that I is a cross-sectional con-
stant in any given year which means I * R,, is a scalar multiple of Ri, in any
given year. Use of annual dummy variables reduces cross-correlation because
the dummies control the effects of economy-wide changes in earnings in each
year.21
Results in table 6 reveal that for the AX,/P,_, variable, all the estimated
coefficients have their predicted signs and are statistically significant. The
coefficient on the interest/return interaction term is highly significant regard-
less of the scale variable. This indicates that the capitalization rate on earnings
and the sensitivity of price changes to earnings changes is not an intertemporal
constant as was assumed in Beaver et al. (1980) and Ohlson (1983).22 When
AX, is scaled by X,_, all coefficients have the same sign as when scaling by
PI_ 1. The coefficients on growth (and/or persistence) and interest rate interac-
tion variables are significant, but the risk coefficient is insignificantly different
from zero. The adjusted R2 is 12.73% using the AX/P,_, variable and 17.98%
using the %AX, variable. By comparison, when we estimate the regression with
an intercept and R, as the only explanatory variable where R, is measured
over the conventional window of April, to March,+, for all firms, the adjusted
R2 is 2.47% using AX/P,_, and 4.01% when using %AX,. Clearly, there is a
substantial improvement in the explanatory power of the model that incorpo-
rates year dummies and risk, growth (and/or persistence), and interest rate
terms to account for variation in the response coefficients.
*tGeneralized least squares would control for the remaining cross-correlation and heteroskedas-
ticity problems, but with only 15 annual observations the variance-covariance matrix cannot be
estimated for a sample of several hundred firms in each year.
**Because of the high collinearity between the return and the interest/return interaction
variables we cannot unambiguously attribute the significance of the interest rate variable to the
RRCs sensitivity to interest rate variation through time. However, results in table 6 and table 4
put together provide compelling evidence that the RRC is related positively to interest rates
through time.
170 D. W. Collins and S.P. Kothari, Variation in earnings response coefficients
Table 6
Effect of risk, growth expectations, and interest rates on the response coefficient from an
earnings/returns relation: Pooled regression analysis using data from 1968-82.*
AX,,/p,,~,or%AX,,=y,+u,,D,,+ . +Y~~D~~+Y~MB,,*R,,+Y~P,,*R,~+Y~~*R,~+~~
D71
0.062** 0.280**
(11.27) (11.77)
D 72 0.076** 0.451**
(14.00) (19.43)
D 73 0.083** 0.504**
(15.28) (21.90)
D 74 0.090** 0.467*
(16.31) (19.88)
45
0.030** 0.180**
(5.75) (7.97)
D 76 0.066** 0.331**
(12.61) (14.86)
D 77 0.067** 0.356**
(12.89) (16.11)
D 7R 0.080** 0.413**
(15.40) (18.54)
D 79 0.069** 0.338**
(13.26) (15.38)
D 80 0.027** 0.119**
(5.10) (5.39)
43,
0.050** 0.230**
(9.56) (10.35)
Growth (MB,, * R,,) _ ? - 0.024** - 0.042**
(- 11.70) (-4.75)
Risk (P,, * K,,) + ? 0.018** PO.013
(3.36) ( - 0.53)
Interest (I, * R,,) + ? 0.012** 0.062**
(15.36) (17.78)
Adjusted R* 12.73% 17.98%
N 9718 9045
Table 6 (continued)
AX,,/f,-1 or %A-%,
= ~0 + YS,, + ~ztMB,t * R,, + Y3rPir
* R,,
where Size;, = 1 for the medium and large firms and 0 for the small firms
where firms are reclassified every year. all other variables are as defined earlier.
For both specifications of the earnings change variable, v4 is not significantly
different from zero. The size coefficient is - 0.008 (t-statistic = - 0.78) when
P1_ 1 is the scale variable and it is 0.022 (t-statistic = 0.44) when X,_, is the
deflator. Once again, when AX, is scaled by Pt_l all of the other coefficients
172 D. W. Collins and S.P. Kothari, Variarion in earnings response coefficients
Table 1
Effect of risk, growth expectations, and firm size on the response coefficients from an earnings/
returns relation: Annual regression analysis from 1968-82.a
AX,,/P,,~,~~%AX,,=~O,+Y,,R,,+~~,MB,,*R,,+Y,,B,,*R,,+~,,S~~~,,*R,,+F,,
have the predicted sign and are statistically significant. Scaling by X,_,
attenuates the influence of risk on the RRC. Growth (and/or persistence)
continues to be significantly associated with the RRC when X,_, is the scale
variable. Overall, the results are consistent with there being no theoretical
justification for incremental explanatory power of the firm size variable on
including risk and growth (and/or persistence) variables to explain cross-sec-
tional variation in the relation between earnings and returns.
earnings variable (VX) pose a nontrivial problem. The problem arises because
the error in estimating earnings persistence using an ARIMA model at the
individual firm level can be large. Moreover, this error is likely to be related to
the error in the proxy for UX. If ERC is estimated using eq. (1) it varies
inversely with the measurement error in the lJXi, proxy and a spurious
correlation between estimated persistence and estimated ERC could result
simply because estimation errors in the two variables are correlated.
We analyze the relation between persistence and response coefficients dif-
ferently from previous research and in a way that reduces the correlated
measurement error problem noted above. We first estimate IMA(l, 1) persis-
tence factors of those firms with a complete earnings history on the Compustat
tape. This data restriction cuts our original sample approximately in half. We
then test the interaction of the estimated persistence variable with returns
(8, * R,,) along with other interaction terms in the cross-sectional regression
equation described earlier in eq. (10) and table 6.23 Since we estimate RRCs
rather than ERCs, the coefficient on persistence is predicted to be negative.
Moreover, the dependent variable is the scaled annual earnings change rather
than the ERCs. Since the dependent variable in our analysis is not conditional
on the individually estimated IMA(1,l) models, potential spurious correlation
because of measurement error is reduced.
The limitation of estimating persistence using reported earnings, as noted
earlier, is that the estimate is confounded by earnings growth. Thus, the
persistence estimates also reflect economic growth and this adversely affects
our ability to separately document the growth and persistence effects.24 Be-
cause both persistence and growth proxies are included in the regressions,
coefficients on each reflect each variables incremental effect on the RRC. If
both proxies are measuring the same underlying construct, then incremental
association of each variable with the RRC implies that neither proxy fully
captures the underlying construct. Unfortunately, this cannot be verified
empirically.
The results of adding the earnings persistence variable to the model for the
reduced subsample of firms are reported in table 8. When the dependent
variable is A X,/P,_ 1 the coefficient on persistence is significantly negative as
predicted (-0.051 with a t-statistic of -4.91). For this specification, all the
other factors that are hypothesized to affect the earnings/returns relation (i.e.,
growth, risk, and interest rates) have the predicted sign and are statistically
D71
0.059** 0.263*
(8.56) (9.17)
D 72 0.077: 0.491**
(11.21) (17.21)
DUl
0.062** 0.333**
(9.10) (11.86)
Growth (MB,, * R,,) ? - 0.024** - 0.066**
(-8.23) (- 5.46)
Risk (P,, * R,,) + ? 0.049** 0.17u**
(5.85) (4.85)
Interest (I, * R,,) ? 0.01s** 0.059**
(12.95) (10.19)
Persistence (0, * R,,) ? - 0.051** 0.062
( - 4.91) (1.36)
Adjusted R2 19.43% 27.33%
N 4841 4587
Table 8 (continued)
Initially any firm listed on the Compustat Industrial Annual or the Compustat Annual
Research tape with a December 31 fiscal year-end and complete earnings data during 1968-82 is
included in the sample. From this sample, the subset for which monthly return data are available
for eight consecutive years ending in 196943 is included in the sample analyzed in this study.
A X,/P,_ 1 is change in EPS from year t - 1 to t divided by share price at the beginning of the
15-month return period. A total of 58 observations with Id X,/P,_, 1z 100% are excluded.
%A X, is change in EPS from year r - 1 to t divided by the EPS for year t - 1. A total of 731
observations with negative denominators or l%AX,1 > 200% are excluded.
R,, is raw return on security i over the relevant return window. R,, is measured over a
15-month period beginning in November of year I - 1 for the small firms and over a 15-month
period beginning in August of year t - 1 for the medium and large firms.
MB,, is the market to book value of equity ratio calculated at the beginning of each year t.
/I,, is the market model systematic risk estimate obtained by regressing 60 monthly returns
ending in year t - 2 on the CRSP equally weighted return index.
I, is the long-term Government bond yield in year r.
Dbx through OR1 are annual intercept dummies which are set = 1 for observations from
respective years 68 through 81 and are set = 0 otherwise.
8, is the persistence coefficient measured as (1 - 0) from an IMA(l.l) process.
Significance at a = 5% is indicated by one asterisk (*) and at a = 1% by two asterisks (**).
One-tailed r-tests are performed when sign of the coefficient is predicted. Otherwise two-tailed
r-tests are performed.
Table 9
Effect of risk, growth expectations and persistence on the response coefficients from an
earnings/returns relation: Annual regression analysis from 1968-82.a
* X,/P,,- I or Ax,, = for + YIN
R,, + Y,,MB,,* 8, + nd,, * R,, + ~a,@,
* 4, + E,I
are scaled by price. However, these factors have less influence on RRCs when
earnings changes are scaled by last years earnings.
Table 10 summarizes how the explanatory power of the earnings/returns
relation is enhanced by varying the return interval and by incorporating terms
that capture the effects of risk, growth, and/or persistence and interest rates
on the RRC. The first two columns report adjusted R*s from models esti-
mated with the full sample, while the last two columns present similar results
for the subsample with complete data throughout our sample period. Compar-
ing the first two rows of table 10 we see that the explanatory power of a model
where earnings changes are regressed on returns more than doubles when we
D. W. Collins and S. P. Kothari, Variation in earnings response coefficients 111
Table 10
Effect of varying the return interval and additional independent variables on the explanatory
power of the regression of earnings changes on returns: Regressions using data from 1968-82.
Sample selection criteria for the full sample are given in footnote a to table 2 and for the
sa?ple consisting of firms with complete data for 15 years are given in footnote a to table 8.
When full sample is used, there is no proxy for persistence included as an independent
variable.
Table values are adjusted Rs from regressing either A X,/P,_ 1 or % X, on the set of variables
indicated in the left-hand column,
dThe 15-month returns that are associated with the earnings change in period I are measured
from August,_ 1 to November, for large and medium firms and November,_, to February,+ 1 for
small firms.
Comparing the first and last row of table 10 shows the dramatic improve-
ment achieved by varying the return interval and allowing nonconstant inter-
cept and slope terms in the earnings/returns relation. For the full sample the
adjusted R2 increases by 415% when the dependent variable is A X,/P,_, and
by 348% when the dependent variable is %AX,. The comparable improvements
for the reduced sample of firms with complete earnings data throughout the 15
years of our study were 821% and 823%. Despite these dramatic improvements
in overall explanatory power it is obvious that a substantial amount of
variation (roughly, 70-80s) in accounting earnings changes is unrelated to
security returns. This suggests there is ample room for further refinement in
the earnings/returns relation and/or that accounting earnings contain a large
noise component that is irrelevant to valuing the firm.
This paper extends the empirical literature on the differences in the relation
between earnings and security returns. Using a simple discounted dividends
valuation model we hypothesize that the earnings response coefficient varies
negatively with the risk-free interest rate and systematic risk; and it varies
positively with growth prospects and earnings persistence. This analysis pre-
dicts cross-sectional and temporal variation in the amount of price change
associated with earnings changes.
Our empirical analyses suggest methodological refinements that have impli-
cations for past and future association study research. We examine the
implications of differences in the information environment which are charac-
teristic of the security market. Specifically, we show that conventional associa-
tion study methods that measure returns over the fiscal 1Zmonth period, or
from April, to March,_ r, seriously understate the degree of association be-
tween price changes and earnings changes in an annual association study
context. The price/earnings association improves dramatically on starting the
measurement period earlier than the contemporaneous fiscal period. Varying
the return measurement period for different size firms controls for the infor-
mation environment differences among the large and small firms and also
explains the previous finding that the degree of price change to earnings
change varies with firm size.
Empirical evidence is consistent with the predictions that the ERC increases
in growth and/or persistence and decreases in interest rates and risk. Because
the proxies used for growth and persistence could potentially reflect the effect
of both variables, we cannot conclude unambiguously that growth and persis-
tence affect ERC individually. To reduce the errors-in-variables problem, we
use reverse regression to document the effect of differences in persistence
and/or growth, risk, and interest rates on the response coefficient.
D. W. Collins and S. P. Kothari, Variation in earnings response coefficients 179
25Easton and ZmiJewski (1989) find a positive relation between firm size and earnings persis-
tence. Moreover, both theoretically and empirically, debt/equity ratios and betas are positively
associated. This implies a negative relation between leverage and ERC. Therefore, research designs
that restrict the ERC to be constant and include either size or leverage in the regression equation
are likely to find significant coefficients on these variables because they proxy for sources of
cross-sectional variation in the ERCs.
180 D. W. Collins and S. P. Kothari, Variation in earnings response coefficients
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